Subject: File No. S7-02-10
From: ed naylor

May 24, 2010

Market volatility on the equities exchanges will not be helped by stock circuit breakers. All that will do is trap people in positions so the market can gap down after the halt.

What needs to be addressed is the lack of Market Makers on the electronic exchanges. On NASDAQ, 10 years ago the MMs had to fill 5000 shares before they could change price. That is now 100 shares i.e. no one is making market. They are HFT in inside the posted bid and offer, but that hardly counts. This subpenny trading does nothing to support the markets.

Rule 612 of Regulation NMS specifically prohibits any exchange, national securities association, alternative trading system, vendor, or broker or dealer from displaying ranking, or accepting a bid or offer, an order, or an indication of interest in any NMS stock priced in an increment smaller than $.01 for shares priced above $1 per share. (The increment declines to $.0001 for shares priced less than $1 per share.) In paragraph c of the rule, however, the Commission reserves the right to exempt any class of persons, securities, quotations, or orders if the Commission determines that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors. In the adopting release for Regulation NMS, the Commission noted that it did not believe that sub-penny trading raised the same concerns as sub-penny quoting. As a consequence, the Commission expressly stated its willingness to grant an exemption to broker-dealers, saying: a broker-dealer could, consistent with the proposed rule, provide price improvement to a customer order that resulted in a sub-penny execution as long as the broker-dealer did not accept an order priced above $1.00 per share in a sub-penny increment. Our reading of this rule is that it was adopted principally to prevent market participants from obtaining execution priority for a nominally better price. The fear was that such incremental price improvements would impair market liquidity and depth. Any exemptions were given to ensure orderly markets and to permit dealers to provide liquidity. While we support the intention of the rule, we believe it has created a two-tiered market for both market participants and for trading venues. First, while the rule prevents bids, offers, orders, or indications of interest priced at increments of less than one penny, it does not prohibit actual sub-penny trades. Consequently, those who can trade without submitting a bid, offer, order, or indication of interest—i.e. certain broker-dealers, and others transacting through less-regulated venues—have an advantage that permits them to pre-empt the NBBO. Second, the Rule applies to exchanges, national securities associations, alternative trading systems, vendors, or brokers or dealers. In practice, the rule appears to exempt so-called dark pool crossing networks from such sub-penny prohibitions. Our members have found that this exemption permits certain market participants to use computer algorithms to preempt the NBBO with sub-penny trades. As a matter of principle and fairness, and out of concern for investor trust in the integrity of financial markets, CFA Institute believes that all market participants and venues should have to abide by the same rules, particularly with respect to sub-penny trading. As shown in the attached presentation, the differentiated rules have created a de facto two-tiered market that is benefiting a few firms at the expense of the greater market. Preempting Limit Order Execution In general, the parties most susceptible to sub-penny trading are those investors who submit passive limit orders. Even when such limit orders represent the NBBO, however, these orders are getting by-passed on a regular basis by other market participants who are able to improve the price by a mere $.0001. The member who prepared the attached presentation says that this happens thousands of times per day to his firms limit orders. In response, weve been told the firms senior management has told the firms traders not to submit passive limit orders. Such responses, while rational, could create long-lasting problems for the markets in the United States. Potential to Impair Price Discovery In its 2004 Regulation NMS proposal, the Commission cited the strong support of large institutional investors for enhanced protection of limit orders. These institutions, the Commission reported: emphasized that limit orders are the building blocks of public price discovery and efficient markets. They stated that a uniform rule for all NMS stocks, by enhancing protection of displayed prices, would encourage greater use of limit orders and contribute to increased market liquidity and depth. The Commission preliminarily agrees that strengthened protection of displayed limit orders would help reward market participants for displaying their trading interest and thereby promote fairer and more vigorous competition among orders seeking to supply liquidity. Given the important benefits for price formation provided by limit orders, we believe it should concern the Commission that many such orders are being preempted by sub-penny trades. If investors are discouraged from submitting limit orders due to the expectation that such orders will be jumped by a sub-penny trade, the price-discovery mechanisms of U.S. securities markets could suffer. In particular, we are concerned that price volatility could increase, with negative consequences for both investor returns and issuer costs of capital. Potential to Loss of Liquidity Providers Equally disconcerting is the potential that sub-penny trades are discouraging liquidity providers. While entities benefiting from such trading may argue that volume from high-frequency trading (HFT) will replace volume from departing liquidity providers, CFA Institute is not reassured. In particular, HFT firms are in the business of trading for their own purposes. They are not there to provide a service to the market. Liquidity providers, such as traditional market makers, on the other hand, supply a much-needed service, in particular during circumstances such as those seen in late 2008 when markets were highly volatile and, at times, in a near freefall. If those liquidity providers ultimately leave the market because of the disparity in trading rules, it could have very serious consequences for market order in future sell-offs. At such times, HFT firms can remove their liquidity by quickly changing their algorithms parameters, and rather than supporting the market with liquidity could join others by selling into the market. Such a circumstance would leave no one to provide a cushion for freefalling share prices. The effects have been devastating for millions of small and institutional investors, alike during the "fat finger" crash.

Enforce Rule 612 to discussion from market participants. In particular, consider how best to ensure all market participants and trading facilities, including dark crossing networks, adhere to the same rules.